Bailout may hit bank bondholders: congressman

WASHINGTON (Reuters) - Bondholders in distressed financial institutions might be next in line to take a hit in the U.S. bank bailout under a debt swap strategy that one member of Congress said on Thursday is under discussion.

Rep. Brad Sherman told Reuters that bank bondholders could be asked to swap bonds that they now have for new “haircut” debt with lower interest rates or face values.

“People are talking about it. It’s not the first choice,” said the California Democrat, who is a member of the U.S. House of Representatives Financial Services Committee.

Four aides to key lawmakers in the House and Senate said they had not heard of any discussion about such a proposal and U.S. Treasury Secretary Timothy Geithner all, but dismissed the idea when asked about it in a U.S. Senate hearing on Thursday.

But Sherman said that asking bondholders to share the pain already being felt by bank stockholders and U.S. taxpayers would “make capitalism work the way it’s supposed to.”

“The ‘new socialism’ is you hit the stockholders and then you hit the taxpayers. I’m not in favor of that,” he said.

Stockholders have been hammered by lower share prices for major banks, while taxpayers are backing a massive bailout, assisting institutions such as Citigroup (C.N), Bank of America (BAC.N) and American International Group Inc (AIG.N).

In contrast, investors in the debt of such institutions have suffered little, making them a tempting target for policy-makers looking for ways to spread the burden of resolving the worst U.S. financial crisis in generations.

A debt swap could help shore up banks’ balance sheets, but Sherman said that powerful allies of wealthy debt-holding investors will have something to say about it.

Geithner, responding to a question about the idea from a member of the Senate Budget Committee, said it would be better and cheaper for taxpayers to ensure that banks can meet their debt obligations.

“It’s not a close call, senator. It is necessary, to protect the financial system and get recovery back on track, for the markets to understand that we would do what’s necessary to make sure that these major institutions can meet their commitments,” Geithner said.

“Everything we’re doing, in terms of making capital available where it’s necessary, providing support in terms of liquidity funding guarantees, is to underscore that commitment to make sure our institutions can meet their commitments,” he added.

Many analysts blame the failure of Lehman Brothers, and its defaulting on its debt obligations, as the trigger that locked up interbank lending and nearly all other credit markets last fall, threatening the financial system with potential collapse. Geithner has vowed not to repeat that mistake.

Market analysts said late last month that debtholders such as insurance companies were concerned about how far up the capital structure losses at banks might extend.

They said debtholders were worried about an equity-for-debt restructuring being used to help recapitalize the banks. In the case of Citigroup, the government recently swapped preferred stock for common equity to bolster its capital cushion.

Lawmakers from both parties in Congress are suffering from bailout fatigue, making it politically difficult for the Obama administration to ask for more money to fix the financial system, although such a request is widely expected.

The Treasury Department said this week it has disbursed $326.8 billion from the $700 billion financial bailout program approved by Congress in October. The Federal Reserve has also extended special assistance to many financial institutions.